Cashflow Doesn't Build Wealth Round 2; How do things look going forward?

[Chester Transo]

After reading the "Cashflow Doesn't Build Wealth" by Shane Pearlman I can see that there are a lot of really passionate opinions on both sides of the fence. There were some really good arguments presented by both sides. I think it's a healthy discussion, with all sides coming away winners in that we all know a little more about alternative strategies.

I could not help noticing though, that many of the arguments being presented tended to deal with past performance. While that's natural, past performance is no guarantee of anything going forward, as we all know.

What I'd like to ask is where do we go from here in this cash flow versus appreciation debate? Rates appear to going nowhere but up so it follows that cap rates will too. Looking forward into a rising rate environment, what does the future hold for the buy-for-appreciation versus cash flow play?

It seems to me that if you purchased an apartment property after the crash and held it until today you were the beneficiary of a historic compression of cap rates due to rates falling to almost zero. The result was a windfall appreciation for doing nothing more than simply holding the property throughout this period.

If however, we look toward rising loan costs and higher cap rates, the potential is real for both a refi bomb that will eat up some or all of your cash flow gains with at the same time, a cap rate expansion that could wipe out any appreciation gains .

So that begs the question of what the correct strategy is going forward?

I'm certainly not a math whizz, but I've put my trusty old HP10bII calculator to work to lay out some scenarios that may help to illustrate my point. I'm enclosing a hypothetical example in a Google doc spreadsheet. Please have a look over my work and tell me if you see any errors in my calculations. You can view/download the spreadsheet here:

https://docs.google.com/spreadsheets/d/1eWquKpM8cd...

Here are my Assumptions:

Market; West Coast (say San Fran )

Cap rate at purchase: 5%

NOI: 200,000

Purchase price: $4 mill

LTV: 65%

Down: $1.4 mil

Finance: 2.6 million

Terms: 5% for 5 year term 25 year amort

NOI Increase 3%/year

NOI end of year 5: 225,101.76

Net cash flow years 1-5: 149,867.16

Principal Reduction years 1-5: 296,915.00

Debt Principal end of year 5: 2,303,085.00

Cap rate at end of year 5: 8%'

Renewal terms: 8% for 5 year term 25 year amort

Exit strategy 1: sell in 5 years

Exit Strategy 2: hold for 10 years with refi in 5 years

Based on above assumptions here is what I see:

Exit Strategy 1

End of Year 5 sell building for 2,813,772.03

Less O/S Debt of 2,303,085.00

Net Profit 510,687.03

Plus 5 Year Cash Flow of ` 149,867

*Principle Reduction (Included) 0

Total Net Proceeds 660,554.19

Less Down Payment 1,400,000.00

Net Loss:  (739,445.81)

* Note-Principal reduction is already included in the reduced O/S debt amount

Exit Strategy 2

End of Year 10 sell building for 3,261,932.96

Less O/S Debt of 2,125,147.00

Net Profit 1,136,785.96

Plus 10 Year Cash Flow of 314,281.00

*Principle Reduction (Included) 0

Total Net Proceeds 1,451,066.82

Less Down Payment 1,400,000.00

Net Gain 51,066.82

* Note-Principal reduction is already included in the reduced O/S debt amount

Given the above scenario, in my view, it does not seem to make any sense to buy now. It makes more sense to hold off on buying until cap rates rise. To illustrate the point, here is a third scenario where I hold off on buying the same building for 5 years as I wait for cap rates to rise.

Same Assumptions with new cap/interest rates/NOI:

Market; West Coast (say San Fran )

Cap rate at purchase: 8%

NOI going in: 225,102

LTV: 65%

Terms: 8% for 5 year term 25 year amort

NOI Increase 3%/year

Purchase price: 2,813,772.03

35% Down 984,820.21

Debt Principal 1,828,951.82

Exit Strategy:

End of Year 5 sell building for 3,261,932.96

Less O/S Debt of 1,802,341.00

Net Profit 1,459,591.96

Plus 5 Year Cash Flow of 326,419.00

Principle Reduction Included 0

Total Net Proceeds 1,786,010.66

Less Down Payment 984,820.21

Net Profit 801,190.45

Given the above cap/rate increase scenario if I were to buy today, and hold for 5 years I could lose my shirt. Otherwise, if I hold for 10 years and then sell, my net profit will be only $51,066.82 for 10 years of work. However if I were to hold off the purchase for 5 years I stand to make a profit of $800,000 for only 5 years work.(versus the $50,000 for 10 years above)

Am I missing something here or does it make no sense to buy right now unless you can be assured that you are directly in the path of a future higher density redevelopment of your property. Even, then, how do you weigh the chances that you will guess the development path correctly versus the risk of a potential loss or no gain if you guess wrong?

I would love to hear everyone's take on the multifamily property investment scenario going forward.